Real Estate: Making the REIT Picks

David Lee of T. Rowe Price Real Estate Fund tells how he's outperforming rivals—and the stock market—and what property groups he likes now

After a great run, real estate investments have suffered over the past year, with the average real estate mutual fund down 18%, according to Morningstar. David Lee has managed the $2.5 billion T. Rowe Price Real Estate Fund (TRREX) since it opened in October 1997, so he has seen tough times before. In the two years after the fund started, shares of real estate investment trusts (REITs) lost almost 20%, even as the Standard & Poor's 500-stock index raced ahead 50%. "Even my family was calling up saying they were going to disown me," Lee jokes.

But starting in 2000, real estate shares went on an incredible seven-year run, ignoring the Internet crash and more than doubling, on average. Lee's fund has gained almost 13% a year over the past 10 years, beating the S&P 500 by more than 8 percentage points annually and performing better than three-quarters of all real estate funds. Boston-based BusinessWeek correspondent Aaron Pressman spoke with Lee at Morningstar's (MORN) annual conference in Chicago on June 27.

Real estate was the best place to be for a while, but that run seems to have ended. What's hurting real estate investment trusts?

After those seven years, a correction wasn't surprising. I won't say it was expected, but it wasn't unexpected. So far this year, we're just about flat, while the overall market is down 8% or more, so we're outperforming again. I suppose you could call it a Pyrrhic victory.

It's as simple as the economy. You've five months of job losses now, and this group correlates closely with job creation. Office buildings require job creation, obviously, and shopping malls need the retailers to grow. So the demand side is down temporarily. We're not at panic button-type levels. Long term, we're very bullish on the U.S. economy. That's been a very good bet.

We're very optimistic about supply. There hasn't been a lot of new commercial real estate construction this year. Commercial construction starts have fallen off a cliff. So that bodes well for an eventual recovery, although I can't predict exactly when it will start.

Has the credit crunch hurt the sector much? Aren't real estate companies frequently in need of fresh loans?

The real question is whether these real estate companies will be able to refinance their debts, and the answer is they've been able to so far. The public companies are prudently capitalized. Look at Simon Property Group (SPG). They just did a debt offering, and it was oversubscribed. They got a very good rate.

Potentially, more difficult times may be ahead for more leveraged companies—some of the private companies. I think banks are going to demand more equity before making those loans.

In general, public REITs aren't heavily leveraged, certainly compared with their private counterparts. The public markets have done a good job of policing that. Anybody who tried got put in the penalty box; it was so expensive for them to raise equity that it didn't make sense. A lot of the companies in our fund have balance sheets to take advantage of potential weakness in the market if there are forced sales.

The consumer is also having a tough time, and I keep reading about retail chains closing stores. Won't that hurt the retail-oriented REITs?

We really like the mall companies. There's good scarcity value in regional malls and not a lot of construction going on in the mall business. Short of going bankrupt, we're not convinced that all these retailers can close their way to profitability. They're going to continue to pay rents to have stores in the highly profitable malls.